Minimize Investment Risk

Buying stocks carries a higher risk than keeping
your money in a savings account or buying U.S. Treasury bonds. There
are many ways to manage the risk of investing in the stock market.
One method is called dollar cost averaging.

You may have heard the strategy, "Buy low, sell
high," when dealing with investing. This is a great idea, but in
practice is almost impossible to do. With the fluctuations in the
market, your best bet is to always be buying. The idea behind
regularly purchasing shares of a security is called dollar cost
averaging.

Overview

Dollar cost averaging requires investing the same
amount of money on a regular basis, usually monthly or quarterly,
regardless of the share price of the stock you are buying. By using
this simple discipline, you are smoothing the market fluctuations by
averaging out your investment costs. If you invest only when the
market is up because you feel optimistic about the future, your
dollars are purchasing fewer shares. However, by purchasing when the
market is down, your dollars will buy you more, giving you a bargain
price. So why not only purchase when the market is low? For years
investors have been trying to do this, and they can't. For you to
attempt this would do nothing but give you a huge headache and
probably hurt your financial status. Dollar cost averaging would
eliminate the necessity of timing the market by providing you with a
lower average cost per share, and also rewarding you with more shares
of a given security.

How Dollar Cost Averaging Works

As an example, let's say you have set aside $12,000
to invest during the next year. You can choose either to invest it
all at once, or in smaller amounts over the course of the upcoming
year.

If you choose to invest it all at once, your $12,000
might grow like this:

Month

Amount Invested

Price Per Unit

Units Purchased

Value

January

$12,000

$14.93

804

$12,000

Year-end value

$12,000

$16.39

804

$13,177.56

If you chose to invest over the whole year
in smaller amounts, your investment may look like this:

Month

Amount Invested

Price Per Unit

Units Purchased

Value

January

$1,000

$14.93

67

$1,000

February

$1,000

$16.95

59

$2,135.70

March

$1,000

$16.13

62

$3,032.44

April

$1,000

$14.08

71

$3,646.72

May

$1,000

$12.05

83

$4,121.10

June

$1,000

$12.05

83

$5,121.25

July

$1,000

$10.99

91

$5,670.84

August

$1,000

$12.99

77

$7,703.07

September

$1,000

$14.08

71

$9,349.12

October

$1,000

$14.93

67

$10,913.83

November

$1,000

$16.95

59

$13,390.05

December

$1,000

$16.13

62

$13,742.76

Year-end Total

$12,000

$16.39

852

$13,964.28

The price per unit of the stock fluctuates
as the market fluctuates. The example reflects that when the price
goes up, you are purchasing fewer shares, but when the price is down,
you can purchase more shares. Over the course of the year, you would
realize an average cost of $14.36 per share, which would allow you to
purchase an additional 48 shares and earn $786.72 more than if you
had not used the method of dollar cost averaging.

Advantages

As an investment strategy, dollar cost averaging will
provide you with a number of advantages. Perhaps the biggest
advantage is that it greatly reduces the risk of losing money on your
investment due to bad timing of stock purchases. By using this
approach, you eliminate the need to decide when to invest, and this
helps you avoid the temptation of trying to time the market, known as
the buy low, sell high strategy. Dollar cost averaging encourages
discipline in your program. For this method to work, you must
purchase a specific dollar amount every month. Although the price of
your investment may drop over the course of one year, if you continue
to invest, you will eventually realize the lower average cost. The
price should eventually regain and pass what it was before, and this
will allow you to sell a larger number of shares at a higher price.
Dollar cost averaging does, over time, smooth out market
fluctuations.

Planning for Retirement

Having enough money to be comfortable when you retire
should be one of the long-term goals of your financial planning. A
401(k) plan will offer you an excellent way to implement dollar cost
averaging. In this type of investment, money is deducted and placed
into your investment plan each pay period. Over time, you will
realize the average lower per-share costs of dollar cost averaging.
Another strategy you can use to build your retirement nest egg is
through the reinvestment of dividends and capital gains. This is also
a form of dollar cost averaging and one of the smartest things
investors can do, as reinvesting usually costs you nothing in
additional fees. You must remember that these plans are like all
other forms of dollar cost averaging that, for them to be successful,
you must continue to systematically purchase securities.

If you are investing small amounts of money over long
periods of time, dollar cost averaging will serve you well. If your
goal is to lessen the risk associated with the inevitable rises and
falls of the stock market, then dollar cost averaging is a good
choice.

If you choose to use this as your investment tool,
you must remember that it neither guarantees profits nor eliminates
losses. It does, however, provide a method of investing that will
reduce anxiety over movements in the investment markets. Dollar cost
averaging will only work if you continue to purchase systematically,
regardless of market fluctuations. In turn, if you want to reap the
rewards of this plan, you must stick with the program.

Perhaps the biggest risk of investing is not investing at all. Before you are ready to enter the market, you must first define the type of investor you are by looking at your goals and the risks you are willing to take to achieve them.